Outside of perhaps the Iraq War and same-sex marriages, no topic is currently more polarizing than Social Security reform. Partisan rhetoric is mounting on both sides of a debate about privatizing the 70-year-old government entitlement program. Under the plan getting a great deal of attention by the Bush Administration, Social Security beneficiaries could invest a portion of their retirement savings in private savings accounts (PSAs), which resemble 401(k)s and other defined-contribution plans.
To be sure, the Social Security debate centers on the financial fate of current and future retirees. But privatization would certainly spawn side effects in finance and business circles. At the very least, PSAs would send a huge amount of money Wall Street’s way. Less well discussed are the big potential effects that privatization could have on corporations and their ability to raise capital.
Much depends on which reform plan, if any, is enacted and on how much money beneficiaries choose to sock away in the accounts, economic experts say. But even if the most moderate privatization plan would produce two stunning results in the capital markets. First, hundreds of billions of PSA dollars would flow into stocks and bonds, possibly during a short period. Second, the federal government would be forced to borrow up to $2 trillion over the next few decades to ensure that the current Social Security Trust Fund is solvent during the transition to a privatized system.
The privatization plan with the most political momentum (dubbed Reform Model 2 by the President’s Commission to Strengthen Social Security) would divert between 2 percent and 4 percent of wages from the Social Security Trust Fund into PSAs. Depending on the investment choices that account holders make, the plan would likely pump between $70 billion and $140 billion annually into the capital markets, according to most estimates, including one from the Government Accountability Office.
Further, the government would have to issue between $900 billion and $2 trillion worth of Treasury bonds to raise enough money to fund the transition. That would enable current retirees to get their benefits while new income is diverted into PSAs. Under Model 2, the proceeds from Treasury bonds — rather than those from tax hikes or a boost in payroll deductions — would be used to bridge the gap during the transition. The President’s Commission calculates that transition payments would last about 20 years.
Based on past trends of the investment of defined-contribution plans and other vehicles, PSA account holders would funnel 50 percent of the $70 billion to $140 billion into equities via index and active mutual funds, says Brad Thompson, an investment strategist with Frost National Bank in San Antonio. The other half would go into corporate bonds (30 percent) and Treasury bonds (20 percent)
Thompson points out that the $30 billion of PSA investments he estimates would be placed in corporate bonds — largely through mutual funds — would be a boost for companies, given that last year about $12 billion worth of corporate debt was issued.
In the short term, demand would outstrip supply. “The increased demand [for corporate debt] should push bond prices up, and the cost of capital down,” he said. What’s more, lower costs of capital would entice some CFOs to swap older, more expensive debt for lower-yielding new debt, Thompson believes. In the longer run, corporations would respond to the signal of cheaper debt by increasing supply. “Eventually, marginal borrowers will have their bonds priced according to their specific credit risk, rather than the effects of a partially privatized Social Security,” he said.
While increased demand may drive up the prices of corporate bonds, the release of a significant amount of government debt could dampen the beneficial environment. “The notion that the [PSA plan would force the] federal government to issue a lot more debt into a world that already has a lot of government paper” could be a problem for corporate issuers, says Joseph Minarik, a former policy director and chief economist for the House Budget Committee during the Clinton Administration. Currently, he’s the director of research at the Committee for Economic Development, which has close ties to major U.S. corporations.
Indeed, if the PSA plan floods the market with new Treasuries, the prices of both government and corporate bonds would likely drop under supply-and-demand pressures, explains Minarik. As a result, he says, companies would be forced to offer a higher yield to compensate.
The relatively fast and hefty inflow of PSA investment capital into the stock market could also create temporary volatility in equity prices. Thompson thinks that the increase in demand for shares — about 4 percent in terms of total market capitalization — would cause prices to rise. However, the price spike, albeit temporary, would be driven by legislation rather than improved corporate earnings. As a result, the inflated price would boost a stock’s price-to-earnings ratio, forcing new investors to pay more for the same corporate earning power.
Those increased share prices would improve the value of shareholders’ portfolios. But since the prices wouldn’t be driven by increased earnings, companies would find it harder to lure new investors, according to Thompson.
Indeed, the rush of capital into overvalued stocks coupled with the allure of a low-interest-rate environment could produce a stock market bubble, notes Carl Haacke, a former economic advisor to President Clinton and founder of Skylight Consulting. If such “super liquidity” ensues, CFOs could have a tough time managing their asset portfolios and even making core investment decisions, adds Haacke.
“A bubble is just a huge cascade of bad investment decisions that happens regardless of where interest rates settle,” says the consultant, whose new book Frenzy: Bubbles, Busts, and How to Come Out Ahead, analyzes investment decisions during bubble markets. “You will see a surge of demand not because CEOs are managing their companies well or identifying new innovative products or customer markets, but…[because of] legislative action,” counsels Haacke.
Marie Leone’s “Capital Ideas” column appears every other Thursday. Contact her at MarieLeone@cfo.com.